4174 Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations

(5) Installment obligations

attributable to sales of certain

property—(i) In general. An installment

obligation acquired by a liquidating

corporation, to the extent attributable to

the sale of property described in

paragraph (c)(5)(ii) of this section, is not

a qualifying obligation if the corporation

is formed or availed of for a principal

purpose of avoiding section 453(b)(2)

(relating to dealer dispositions and

certain other dispositions of personal

property), section 453(i) (relating to

sales of property subject to recapture),

or section 453(k) (relating to

dispositions under a revolving credit

plan and sales of stock or securities

traded on an established securities

market) through the use of a party

bearing a relationship, either directly or

indirectly, described in section 267(b) to

any shareholder of the corporation.

(ii) Covered property. Property is

described in this paragraph (c)(5)(ii) if,

within 12 months before or after the

adoption of the plan of liquidation, the

property was owned by any shareholder

and—

(A) The shareholder regularly sold or

otherwise disposed of personal property

of the same type on the installment plan

or the property is real property that the

shareholder held for sale to customers

in the ordinary course of a trade or

business (provided the property is not

described in section 453(l)(2) (relating to

certain exceptions to the definition of

dealer dispositions));

(B) The sale of the property by the

shareholder would result in recapture

income (within the meaning of section

453(i)(2)), but only if the amount of the

recapture income is equal to or greater

than 50 percent of the property’s fair

market value on the date of the sale by

the corporation;

(C) The property is stock or securities

that are traded on an established

securities market; or

(D) The sale of the property by the

shareholder would have been under a

revolving credit plan.

(iii) Safe harbor. Paragraph (c)(5)(i) of

this section will not apply to the

liquidation of a corporation if, on the

date the plan of complete liquidation is

adopted and thereafter, less than 15

percent of the fair market value of the

corporation’s assets is attributable to

property described in paragraph

(c)(5)(ii) of this section.

(iv) Example. The provisions of this

paragraph (c)(5) are illustrated by the

following example:

Example. Ten percent of the fair market

value of the assets of T is attributable to stock

and securities traded on an established

securities market. T owns no other assets

described in paragraph (c)(5)(ii) of this

section. T, after adopting a plan of complete

liquidation, sells all of its stock and

securities holdings to C corporation in

exchange for an installment obligation

bearing adequate stated interest, sells all of

its other assets to B corporation for cash, and

distributes the cash and installment

obligation to its sole shareholder, A, in a

complete liquidation that satisfies section

453(h)(1)(A). Because the C installment

obligation arose from a sale of publicly

traded stock and securities, T cannot report

the gain on the sale under the installment

method pursuant to section 453(k)(2). In the

hands of A, however, the C installment

obligation is treated as having arisen out of

a sale of the stock of T corporation. In

addition, the general rule of paragraph

(c)(5)(i) of this section does not apply, even

if a principal purpose of the liquidation was

the avoidance of section 453(k)(2), because

the fair market value of the publicly traded

stock and securities is less than 15 percent

of the total fair market value of T’s assets.

Accordingly, section 453(k)(2) does not apply

to A, and A may use the installment method

to report the gain recognized on the

payments it receives in respect of the

obligation.

(d) Liquidating distributions received

in more than one taxable year. If a

qualifying shareholder receives

liquidating distributions to which this

section applies in more than one taxable

year, the shareholder must reasonably

estimate the gain attributable to

distributions received in each taxable

year. In allocating basis to calculate the

gain for a taxable year, the shareholder

must reasonably estimate the

anticipated aggregate distributions. For

this purpose, the shareholder must take

into account distributions and other

relevant events or information that the

shareholder knows or reasonably could

know up to the date on which the

federal income tax return for that year

is filed. If the gain for a taxable year is

properly taken into account on the basis

of a reasonable estimate and the exact

amount is subsequently determined the

difference, if any, must be taken into

account for the taxable year in which

the subsequent determination is made.

However, the shareholder may file an

amended return for the earlier year in

lieu of taking the difference into account

for the subsequent taxable year.

(e) Effective date. This section is

applicable to distributions of qualifying

installment obligations made on or after

January 28, 1998.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: December 18, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 98–1820 Filed 1–27–98; 8:45 am]

BILLING CODE 4830–01–U

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8760]

RIN 1545–AU72 and 1545–AU73

Continuity of Interest and Continuity of

Business Enterprise

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations providing guidance

regarding satisfaction of the continuity

of interest and continuity of business

enterprise requirements for corporate

reorganizations. The final regulations

affect corporations and their

shareholders.

DATES: These regulations are effective

January 28, 1998.

Applicability: These regulations apply

to transactions occurring after January

28, 1998, except that they do not apply

to any transaction occurring pursuant to

a written agreement which is (subject to

customary conditions) binding on

January 28, 1998, and at all times

thereafter.

FOR FURTHER INFORMATION CONTACT:

Regarding § 1.368–1(e) (continuity of

interest) §§ 1.338–2 and 1.368–1 (a) and

(b): Phoebe Bennett, (202) 622–7750 (not

a toll-free number); regarding § 1.368–

1(d) (continuity of business enterprise)

and, §§ 1.368–1 (a) and (b), 1.368–2(k):

Marlene Peake Oppenheim, (202) 622–

7750 (not a toll free number).

SUPPLEMENTARY INFORMATION:

Background

On December 23, 1996, the IRS

published a notice of proposed

rulemaking (REG–252231–96) in the

Federal Register (61 FR 67512) relating

to the continuity of interest (COI)

requirement (proposed COI regulations).

On January 3, 1997, the IRS published

a notice of proposed rulemaking (REG–

252233–96) in the Federal Register (62

FR 36101) (proposed COBE regulations)

relating to (1) the continuity of business

enterprise (COBE) requirement; and (2)

transfers of acquired assets or stock

following certain otherwise qualifying

reorganizations (remote continuity of

interest). Many written comments were

received in response to these notices of

proposed rulemaking. A public hearing

on both proposed regulations was held

on May 7, 1997. After consideration of

all comments, the regulations proposed

by REG–252231–96 and REG–252233–

96 are adopted as revised by this
Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations 4175

Treasury decision, along with temporary

regulations and proposed regulations

cross-referencing the temporary

regulations regarding COI published

elsewhere in this issue of the Federal

Register.

Explanation of Provisions

The Internal Revenue Code of 1986

provides general nonrecognition

treatment for reorganizations

specifically described in section 368. In

addition to complying with the statutory

requirements and certain other

requirements, a transaction generally

must satisfy the continuity of interest

requirement and the continuity of

business enterprise requirement.

A. Continuity of Interest

The purpose of the continuity of

interest requirement is to prevent

transactions that resemble sales from

qualifying for nonrecognition of gain or

loss available to corporate

reorganizations. The final regulations

provide that the COI requirement is

satisfied if in substance a substantial

part of the value of the proprietary

interest in the target corporation (T) is

preserved in the reorganization. A

proprietary interest in T is preserved if,

in a potential reorganization, it is

exchanged for a proprietary interest in

the issuing corporation (P), it is

exchanged by the acquiring corporation

for a direct interest in the T enterprise,

or it otherwise continues as a

proprietary interest in T. The issuing

corporation means the acquiring

corporation (as the term is used in

section 368(a)), except that, in

determining whether a reorganization

qualifies as a triangular reorganization

(as defined in § 1.358–6(b)(2)), the

issuing corporation means the

corporation in control of the acquiring

corporation. However, a proprietary

interest in T is not preserved if, in

connection with the potential

reorganization, it is acquired by P for

consideration other than P stock, or P

stock furnished in exchange for a

proprietary interest in T if the potential

reorganization is redeemed. All facts

and circumstances must be considered

in determining whether, in substance, a

proprietary interest in T is preserved.

Rationale for the COI Regulations

The proposed and final regulations

permit former T shareholders to sell P

stock received in a potential

reorganization to third parties without

causing the reorganization to fail to

satisfy the COI requirement. Some

commentators have questioned whether

the regulations are consistent with

existing authorities.

The COI requirement was applied first

to reorganization provisions that did not

specify that P exchange a proprietary

interest in P for a proprietary interest in

T. Supreme Court cases imposed the

COI requirement to further

Congressional intent that tax-free status

be accorded only to transactions where

P exchanges a substantial proprietary

interest in P for a proprietary interest in

T held by the T shareholders rather than

to transactions resembling sales. See

LeTulle v. Scofield, 308 U.S. 415 (1940);

Helvering v. Minnesota Tea Co., 296

U.S. 378 (1935); Pinellas Ice & Cold

Storage Co. v. Commissioner, 287 U.S.

462 (1933). See also Cortland Specialty

Co. v. Commissioner, 60 F.2d 937 (2d

Cir. 1932), cert. denied 288 U.S. 599

(1933).

None of the Supreme Court cases

establishing the COI requirement

addressed the issue of whether sales by

former T shareholders of P stock

received in exchange for T stock in the

potential reorganization cause the COI

requirement to fail to be satisfied. Since

then, however, some courts have

premised decisions on the assumption

that sales of P stock received in

exchange for T stock in the potential

reorganization may cause the COI

requirement to fail to be satisfied.

McDonald’s Restaurants of Illinois, Inc.

v. Commissioner, 688 F.2d 520 (7th Cir.

1982); Penrod v. Commissioner, 88 T.C.

1415 (1987); Heintz v. Commissioner, 25

T.C. 132 (1955), nonacq., 1958–2 C.B. 9;

Estate of Elizabeth Christian v.

Commissioner, 57 T.C.M. (CCH) 1231

(1989). The apparent focus of these

cases is on whether the T shareholders

intended on the date of the potential

reorganization to sell their P stock and

the degree, if any, to which P facilitates

the sale. Based on an intensive inquiry

into nearly identical facts, some of these

cases held that as a result of the

subsequent sale the potential

reorganization did not satisfy the COI

requirement; others held that

satisfaction of the COI requirement was

not adversely affected by the subsequent

sale. The IRS and Treasury Department

have concluded that the law as reflected

in these cases does not further the

principles of reorganization treatment

and is difficult for both taxpayers and

the IRS to apply consistently.

Therefore, consistent with

Congressional intent and the Supreme

Court precedent which distinguishes

between sales and reorganizations, the

final regulations focus the COI

requirement generally on exchanges

between the T shareholders and P.

Under this approach, sales of P stock by

former T shareholders generally are

disregarded.

The final regulations will greatly

enhance administrability in this area by

both taxpayers and the government. The

regulations will prevent ‘‘whipsaw’’ of

the government, such as where the

former T shareholders treat the

transaction as a tax-free reorganization,

and P later disavows reorganization

treatment to step up its basis in the T

assets based on the position that sales of

P stock by the former T shareholders did

not satisfy the COI requirement. See,

e.g., McDonald’s Restaurants, supra. In

addition, this approach will prevent

unilateral sales of P stock by former

majority T shareholders from adversely

affecting the section 354 nonrecognition

treatment expected by former minority

T shareholders.

Dispositions of T Stock

The proposed COI regulations do not

specifically address the effect upon COI

of dispositions of T stock prior to a

potential reorganization, but ask for

comments on that issue. The IRS and

Treasury Department believe that issues

concerning the COI requirement raised

by dispositions of T stock before a

potential reorganization correspond to

those raised by subsequent dispositions

of P stock furnished in exchange for T

stock in the potential reorganization. As

requested by commentators, the final

regulations apply the rationale of the

proposed COI regulations to

transactions occurring both prior to and

after a potential reorganization. Cf. J.E.

Seagram Corp. v. Commissioner, 104

T.C. 75 (1995) (sales of T stock prior to

a potential reorganization do not affect

COI if not part of the plan of

reorganization). The final regulations

provide that, for COI purposes, a mere

disposition of T stock prior to a

potential reorganization to persons not

related to P is disregarded and a mere

disposition of P stock received in a

potential reorganization to persons not

related to P is disregarded. But see

§ 1.368–1T(e)(1)(ii)(A) and (B).

In soliciting comments on the effect

upon COI of dispositions of T stock

prior to a potential reorganization, the

preamble to the proposed COI

regulations specifically requests

comments on King Enterprises, Inc. v.

United States, 418 F.2d 511 (Ct. Cl.

1969) (COI requirement satisfied where,

pursuant to a plan, P acquires the T

stock for 51 percent P stock and 49

percent debt and cash, and T merges

upstream into P), and Yoc Heating Corp.

v. Commissioner, 61 T.C. 168 (1973)

(COI requirement not satisfied where,

pursuant to a plan, P acquires 85

percent of the T stock for cash and

notes, and T merges into P’s newly

formed subsidiary with minority
4176 Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations

shareholders receiving cash). Consistent

with these cases, where the step

transaction doctrine applies to link T

stock purchases with later acquisitions

of T, the final regulations provide that

a proprietary interest in T is not

preserved if, in connection with the

potential reorganization, it is acquired

by P for consideration other than P

stock. Whether a stock acquisition is

made in connection with a potential

reorganization will be determined based

on the facts and circumstances of each

case. See generally § 1.368–1(a). This

regulation does not address the effect, if

any, of section 338 on corporate

transactions (except for conforming

changes to § 1.338–2(c)(3)). See

generally § 1.338–2(c)(3) (certain tax

effects of a qualified stock purchase

without a section 338 election on the

post-acquisition elimination of T).

Related Person Rule

The proposed COI regulations provide

that ‘‘[i]n determining whether [COI is

satisfied], all facts and circumstances

must be considered, including any plan

or arrangement for the acquiring

corporation or its successor corporation

(or a person related to the acquiring

corporation or its successor corporation

within the meaning of section 707(b)(1)

or 267(b) (without regard to section

267(e))) to redeem or acquire the

consideration provided in the

reorganization.’’ The final regulations

provide a more specific rule that a

proprietary interest in T is not preserved

if, in connection with a potential

reorganization, a person related (as

defined below) to P acquires, with

consideration other than a proprietary

interest in P, T stock or P stock

furnished in exchange for a proprietary

interest in T in the potential

reorganization. The IRS and Treasury

Department believe, however, that

certain related party acquisitions

preserve a proprietary interest in T and

therefore, the rule includes an exception

to the related party rule. Under this

exception, a proprietary interest in T is

preserved to the extent those persons

who were the direct or indirect owners

of T prior to the potential reorganization

maintain a direct or indirect proprietary

interest in P. See, e.g., Rev. Rul. 84–30

(1984–1 C.B. 114).

Commentators stated that the

proposed COI regulations’ rule, which

employs sections 707(b)(1) and 267(b) to

define persons related to P, is too broad.

In response, the final regulations adopt

a narrower related person definition

which has two components in order to

address two separate concerns.

First, the IRS and Treasury

Department were concerned that

acquisitions of T or P stock by a member

of P’s affiliated group were no different

in substance from an acquisition or

redemption by P, because of the

existence of various provisions in the

Code that permit members to transfer

funds to other members without

significant tax consequences.

Accordingly, § 1.368–1(e)(3)(i)(A)

includes as related persons corporations

that are members of the same affiliated

group under section 1504, without

regard to the exceptions in section

1504(b).

Second, because the final regulations

take into account whether, in substance,

P has redeemed the stock it exchanged

for T stock in the potential

reorganization, the final regulations

treat two corporations as related persons

if a purchase of the stock of one

corporation by another corporation

would be treated as a distribution in

redemption of the stock of the first

corporation under section 304(a)(2)

(determined without regard to § 1.1502–

80(b)).

Because the final regulations focus

generally on the consideration P

exchanges, related persons do not

include individual or other

noncorporate shareholders. Thus, the

IRS will no longer apply the holdings of

South Bay Corporation v.

Commissioner, 345 F.2d 698 (2d Cir.

1965), and Superior Coach of Florida,

Inc. v. Commissioner, 80 T.C. 895

(1983), to transactions governed by

these regulations.

T Stock Not Acquired in Connection

With a Potential Reorganization

Commentators requested clarification

of whether P must actually furnish stock

to T shareholders that own T stock

which was not acquired in connection

with a potential reorganization. The

final regulations provide that a

proprietary interest in T is preserved if

it is exchanged by the acquiring

corporation (which may or may not also

be P) for a direct interest in the T

enterprise, or otherwise continues as a

proprietary interest in T.

Redemptions of T Stock or

Extraordinary Distributions With

Respect to T Stock

In addition to the final regulations,

the IRS and Treasury Department are

contemporaneously issuing temporary

regulations and proposed regulations

cross-referencing the temporary

regulations published elsewhere in this

issue of the Federal Register with the

same effective date as these final

regulations. The temporary and

proposed regulations provide that a

proprietary interest in T is not preserved

if, in connection with a potential

reorganization, it is redeemed or

acquired by a person related to T, or to

the extent that, prior to and in

connection with a potential

reorganization, an extraordinary

distribution is made with respect to it.

Transactions Following a Qualified

Stock Purchase

As stated above, these final

regulations focus the COI requirement

generally on exchanges between the T

shareholders and P. Accordingly, the

language of § 1.338–2(c)(3) is conformed

to these final COI regulations to treat the

stock of T acquired by the purchasing

corporation in the qualified stock

purchase as though it was not acquired

in connection with the transfer of the T

assets.

Effect on Other Authorities

The IRS and Treasury Department

continue to study the role of the COI

requirement in section 368(a)(1)(D)

reorganizations and section 355

transactions. Therefore, these final COI

regulations do not apply to section

368(a)(1)(D) reorganizations and section

355 transactions. See § 1.355–2(c).

These COI regulations apply solely for

purposes of determining whether the

COI requirement is satisfied. No

inference should be drawn from any

provision of this regulation as to

whether other reorganization

requirements are satisfied, for example,

whether P has issued solely voting stock

for purposes of section 368(a)(1)(B) or

(C).

Effect on Other Documents

Rev. Proc. 77–37 (1977–2 C.B. 568)

and Rev. Proc. 86–42 (1986–2 C.B. 722)

will be modified to the extent

inconsistent with these regulations.

Rev. Rul. 66–23 (1966–1 C.B. 67) is

hereby obsoleted because it indicates

that a plan or arrangement in

connection with a potential

reorganization for disposition of stock to

unrelated persons does not satisfy the

COI requirement.

B. Continuity of Business Enterprise

The COBE requirement is

fundamental to the notion that tax-free

reorganizations merely readjust

continuing interests in property. In

§ 1.368–1(d), as effective prior to these

final regulations, COBE generally

required the acquiring corporation to

either continue a significant historic T

business or use a significant portion of

T’s historic business assets in a

business. However, a valid

reorganization may qualify as tax-free

even if the acquiring corporation does
Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations 4177

not directly carry on the historic T

business or use the historic T assets in

a business. See section 368(a)(2)(C). See

also Rev. Rul. 68–261 (1968–1 C.B. 147);

Rev. Rul. 81–247 (1981–1 C.B. 87).

Consistent with the view that the

acquiring corporation need not directly

conduct the T business or use the T

assets, the final regulations provide

rules under which, in an otherwise

qualifying corporate reorganization, the

assets and the businesses of the

members of a qualified group of

corporations are treated as assets and

businesses of the issuing corporation.

Accordingly, in the final regulations,

COBE requires that the issuing

corporation either continue T’s historic

business or use a significant portion of

T’s historic business assets in a

business.

A qualified group is one or more

chains of corporations connected

through stock ownership with the

issuing corporation, but only if the

issuing corporation owns directly stock

meeting the requirements of section

368(c) in at least one of the

corporations, and stock meeting the

requirements of section 368(c) in each of

the corporations is owned directly by

one of the other corporations.

The judicial continuity of interest

doctrine historically included a concept

commonly known as remote continuity

of interest. Commonly viewed as arising

out of Groman v. Commissioner, 302

U.S. 82 (1937), and Helvering v.

Bashford, 302 U.S. 454 (1938), remote

continuity of interest focuses on the link

between the T shareholders and the

former T business assets following the

reorganization. In § 1.368–1(d), as

effective prior to these final regulations,

COBE focuses on the continuation of T’s

business, or the use of T’s business

assets, by the acquiring corporation.

Section 1.368–1(d), as revised herein,

expands this concept by treating the

issuing corporation as conducting a T

business or owning T business assets if

these activities are conducted by a

member of the qualified group or, in

certain cases, by a partnership that has

a member of the qualified group as a

partner.

The proposed COBE regulations

separately address COBE (§ 1.368–1(d))

and remote continuity of interest

(§ 1.368–1(f)). The IRS and Treasury

Department believe the COBE

requirements adequately address the

issues raised in Groman and Bashford

and their progeny. Thus, these final

regulations do not separately articulate

rules addressing remote continuity of

interest.

Definition of the Qualified Group

The proposed COBE regulations

define the qualified group using a

control test based on section 368(c). The

IRS and Treasury Department received

comments suggesting the replacement of

the section 368(c) definition of control

by the affiliated group definition of

control stated in section 1504, without

regard to section 1504(b). However,

because section 368 generally

determines control by reference to

section 368(c), the final regulations

retain the approach of the proposed

COBE regulations.

Rules for Aggregation of Interests in

Historic T Assets and Businesses Held

in Partnership Solution

In determining whether COBE is

satisfied, the proposed COBE

regulations aggregate the interests of the

members of a qualified group. In

addition, the proposed COBE

regulations attribute a business of a

partnership to a corporate transferor

partner if the partner has a sufficient

nexus with that partnership business.

However, the proposed COBE

regulations only consider the transferor

partner’s interest in the partnership

business, and do not aggregate this

interest with interests in the partnership

held by other members of the qualified

group.

In response to comments requesting a

partnership aggregation rule, the final

regulations, through a system of

attribution, aggregate the interests in a

partnership business held by all the

members of a qualified group. The final

regulations provide rules under which a

corporate partner may be treated as

holding assets of a business of a

partnership. Additionally, P is treated as

holding all the assets, and conducting

all the businesses of its qualified group.

Furthermore, in certain circumstances,

P will be treated as conducting a

business of a partnership. Once the

relevant T businesses and T assets are

attributed to P, COBE is tested under the

general rule of the final COBE

regulations. See § 1.368–1(d)(1).

The proposed COBE regulations do

not discuss tiered partnerships. In

response to comments, the final

regulations provide guidance on this

issue. See § 1.368–1(d)(5), Example 12.

C. Transfers of Assets or Stock to

Controlled Corporations as Part of a

Plan of Reorganization

The proposed COBE regulations are

limited in their application to COBE and

remote continuity of interest. The rules

of the proposed COBE regulations

provide that for certain reorganizations,

transfers of acquired assets or stock

among members of the qualified group,

and in certain cases, transfers of

acquired assets to partnerships, do not

disqualify a transaction from satisfying

the COBE and remote continuity of

interest requirements. The preamble to

the proposed COBE regulations states

that these rules do not address any other

issues concerning the qualification of a

transaction as a reorganization.

Comments suggest that the proposed

COBE regulations are ambiguous as they

could be interpreted to mean that a

transfer of stock or assets to a qualified

group member after an otherwise taxfree reorganization would be given

independent significance and the step

transaction doctrine would not apply.

Under such an interpretation, the

potential reorganization would not be

recast as a taxable acquisition or another

type of reorganization. To eliminate this

ambiguity, § 1.368–1(a) of the final

regulations provides that, in

determining whether a transaction

qualifies as a reorganization under

section 368(a), the transaction must be

evaluated under relevant provisions of

law, including the step transaction

doctrine. Section 1.368–1(d) of the final

regulations is limited to a discussion of

the COBE requirement, and does not

address satisfaction of the explicit

statutory requirements of a

reorganization, which is the subject of

§ 1.368–2. However, § 1.368–2(k) of the

final regulations does provide guidance

in this regard, extending the application

of section 368(a)(2)(C) to certain

successive transfers.

Section 1.368–2(k) of the final

regulations states that a transaction

otherwise qualifying under section

368(a)(1) (A), (B), (C), or (G) (where the

requirements of sections 354(b)(1) (A)

and (B) are met) shall not be

disqualified by reason of the fact that

part or all of the acquired assets or stock

acquired in the transaction are

transferred or successively transferred to

one or more corporations controlled in

each transfer by the transferor

corporation. Control is defined under

section 368(c). The final regulations also

provide a rule for transfers of assets

following a reorganization qualifying

under section 368(a)(1)(A) by reason of

section 368(a)(2)(E). No inference is to

be drawn as to whether transactions not

described in § 1.368–2(k) otherwise

qualify as reorganizations.

The final regulations also provide

that, if a transaction otherwise qualifies

as a reorganization, a corporation

remains a party to the reorganization

even though stock or assets acquired in

the reorganization are transferred in a

transaction described in § 1.368–2(k).
4178 Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations

See § 1.368–2(f). Furthermore, if a

transaction otherwise qualifies as a

reorganization, a corporation shall not

cease to be a party to the reorganization

solely because acquired assets are

transferred to a partnership in which the

transferor is a partner if the COBE

requirement is satisfied.

Section 368(a)(1)(D), 368(a)(1)(F), and

355 Transactions

The proposed COBE regulations,

applying only to the COBE and remote

continuity of interest requirements, are

limited to transactions otherwise

qualifying for reorganization treatment

under section 368(a)(1) (A), (B), (C), or

(G) (where the requirements of sections

354(b)(1) (A) and (B) are met). The IRS

and Treasury Department received

comments stating that the final

regulations should apply to

reorganizations qualifying under section

368(a)(1) (D) or (F) or to transactions

qualifying under section 355.

The final regulations do not limit the

application of § 1.368–1(d) to the

transactions enumerated in section

368(a)(2)(C). The COBE provisions in

the final regulations apply to all

reorganizations for which COBE is

relevant.

Section 1.368–2(k)(1) of the final

regulations, however, is limited in its

application to the transactions described

in section 368(a)(2)(C), and does not

apply in determining whether a

reorganization qualifies under section

368(a)(1)(D), section 368(a)(1)(F), or

section 355. The IRS and Treasury

Department believe that further study is

needed prior to extending § 1.368–

2(k)(1) to one or more of these

provisions.

Effective Date

The amendments to these regulations

apply to transactions occurring after

January 28, 1998, except that they do

not apply to any transaction occurring

pursuant to a written agreement which

is (subject to customary conditions)

binding on January 28, 1998, and at all

times thereafter. Commentators

requested that the effective date be

changed to allow these regulations to

apply to transactions occurring on or

before January 28, 1998. The IRS and

Treasury Department believe that

adopting an earlier effective date

increases the likelihood that T, P, and

each of the former T shareholders would

report the transaction inconsistently (in

some cases using hindsight), and would

reduce administrability of the

regulation. No inference should be

drawn from any provision of this

regulation as to application of the COI

or COBE requirements to transactions

occurring on or before January 28, 1998.

Special Analyses

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

12866. Therefore, a regulatory

assessment is not required. It also has

been determined that section 553(b) of

the Administrative Procedure Act (5

U.S.C. chapter 5) does not apply to these

regulations, and because the regulation

does not impose a collection of

information on small entities, the

Regulatory Flexibility Act (5 U.S.C.

chapter 6) does not apply. Pursuant to

section 7805(f) of the Internal Revenue

Code, the notices of proposed

rulemaking preceding these regulations

were submitted to the Chief Counsel for

Advocacy of the Small Business

Administration for comment on their

impact on small business.

Drafting Information

The principal authors of these

regulations are Phoebe Bennett,

regarding § 1.368–1(e) (continuity of

interest), and Marlene Peake

Oppenheim, regarding § 1.368–1(d)

(continuity of business enterprise) and

§ 1.368–2(k), both of the Office of the

Assistant Chief Counsel (Corporate),

IRS. However, other personnel from the

IRS and Treasury Department

participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and

recordkeeping requirements.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 continues to read in part as

follows:

Authority: 26 U.S.C. 7805. * * *

Par. 2. Section 1.338–2 is amended:

1. By revising paragraph (c)(3)(ii).

2. In paragraph (c)(3)(iv) example, by

revising the first sentence of paragraph

(B).

The revisions read as follows:

§ 1.338–2 Miscellaneous issues under

section 338.

* * * * *

(c) * * *

(3) * * *

(ii) Continuity of interest. By virtue of

section 338, in determining whether the

continuity of interest requirement of

§ 1.368–1 (b) and (e) is satisfied on the

transfer of assets from target to the

transferee, the purchasing corporation’s

target stock acquired in the qualified

stock purchase shall be treated as

though it was not acquired in

connection with the transfer of target

assets.

* * * * *

(iv) Example. * * *

(B) Status of transfer as a

reorganization. By virtue of section 338,

for the purpose of determining whether

the continuity of interest requirement of

§ 1.368–1(b) is satisfied, P’s T stock

acquired in the qualified stock purchase

shall be treated as though it was not

acquired in connection with the transfer

of T assets to X. * * *

* * * * *

Par. 3. Section 1.368–1 is amended

by:

1. Adding three sentences

immediately following the first sentence

of paragraph (a).

2. Removing the third sentence and

adding four sentences in its place to

paragraph (b).

3. Removing paragraph (d)(1).

4. Redesignating paragraphs (d)(2),

(d)(3), and (d)(4) as paragraphs (d)(1),

(d)(2), and (d)(3), respectively.

5. Removing the first sentence of

newly designated paragraph (d)(1) and

adding two sentences in its place.

6. Adding new paragraph (d)(4).

7. Paragraph (d)(5) is amended by:

a. Adding two sentences to the end of

paragraph (d)(5) introductory text.

b. Removing the parentheses around

the numbers in the paragraph headings

for Example (1) through Example (5).

c. Adding Example 6 through

Example 12.

8. Adding paragraph (e).

The additions and revisions read as

follows:

§ 1.368–1 Purpose and scope of exception

of reorganization exchanges.

(a) * * * In determining whether a

transaction qualifies as a reorganization

under section 368(a), the transaction

must be evaluated under relevant

provisions of law, including the step

transaction doctrine. But see §§ 1.368–2

(f) and (k) and 1.338–2(c)(3). The

preceding two sentences apply to

transactions occurring after January 28,

1998, except that they do not apply to

any transaction occurring pursuant to a

written agreement which is binding on

January 28, 1998, and at all times

thereafter. * * *

(b) * * * Requisite to a reorganization

under the Internal Revenue Code are a

continuity of the business enterprise

through the issuing corporation under

the modified corporate form as

described in paragraph (d) of this
Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations 4179

section, and (except as provided in

section 368(a)(1)(D)) a continuity of

interest as described in paragraph (e) of

this section. (For rules regarding the

continuity of interest requirement under

section 355, see § 1.355–2(c).) For

purposes of this section, the term

issuing corporation means the acquiring

corporation (as that term is used in

section 368(a)), except that, in

determining whether a reorganization

qualifies as a triangular reorganization

(as defined in § 1.358–6(b)(2)), the

issuing corporation means the

corporation in control of the acquiring

corporation. The preceding three

sentences apply to transactions

occurring after January 28, 1998, except

that they do not apply to any transaction

occurring pursuant to a written

agreement which is binding on January

28, 1998, and at all times thereafter.

* * *

* * * * *

(d) Continuity of business enterprise—

(1) General rule. Continuity of business

enterprise (COBE) requires that the

issuing corporation (P), as defined in

paragraph (b) of this section, either

continue the target corporation’s (T’s)

historic business or use a significant

portion of T’s historic business assets in

a business. The preceding sentence

applies to transactions occurring after

January 28, 1998, except that it does not

apply to any transaction occurring

pursuant to a written agreement which

is binding on January 28, 1998, and at

all times thereafter. * * *

* * * * *

(4) Acquired assets or stock held by

members of the qualified group or

partnerships. The following rules apply

in determining whether the COBE

requirement of paragraph (d)(1) of this

section is satisfied:

(i) Businesses and assets of members

of a qualified group. The issuing

corporation is treated as holding all of

the businesses and assets of all of the

members of the qualified group, as

defined in paragraph (d)(4)(ii) of this

section.

(ii) Qualified group. A qualified group

is one or more chains of corporations

connected through stock ownership

with the issuing corporation, but only if

the issuing corporation owns directly

stock meeting the requirements of

section 368(c) in at least one other

corporation, and stock meeting the

requirements of section 368(c) in each of

the corporations (except the issuing

corporation) is owned directly by one of

the other corporations.

(iii) Partnerships—(A) Partnership

assets. Each partner of a partnership

will be treated as owning the T business

assets used in a business of the

partnership in accordance with that

partner’s interest in the partnership.

(B) Partnership businesses. The

issuing corporation will be treated as

conducting a business of a partnership

if —

(1) Members of the qualified group, in

the aggregate, own an interest in the

partnership representing a significant

interest in that partnership business; or

(2) One or more members of the

qualified group have active and

substantial management functions as a

partner with respect to that partnership

business.

(C) Conduct of the historic T business

in a partnership. If a significant historic

T business is conducted in a

partnership, the fact that P is treated as

conducting such T business under

paragraph (d)(4)(iii)(B) of this section

tends to establish the requisite

continuity, but is not alone sufficient.

(iv) Effective date. This paragraph

(d)(4) applies to transactions occurring

after January 28, 1998, except that it

does not apply to any transaction

occurring pursuant to a written

agreement which is binding on January

28, 1998, and at all times thereafter.

(5) * * * All corporations have only

one class of stock outstanding. The

preceding sentence and paragraph (d)(5)

Example 6 through Example 12 apply to

transactions occurring after January 28,

1998, except that they do not apply to

any transaction occurring pursuant to a

written agreement which is binding on

January 28, 1998, and at all times

thereafter.

* * * * *

Example 6. Use of a significant portion of

T’s historic business assets by the qualified

group. (i) Facts. T operates an auto parts

distributorship. P owns 80 percent of the

stock of a holding company (HC). HC owns

80 percent of the stock of ten subsidiaries, S–

1 through S–10. S–1 through S–10 each

separately operate a full service gas station.

Pursuant to a plan of reorganization, T

merges into P and the T shareholders receive

solely P stock. As part of the plan of

reorganization, P transfers T’s assets to HC,

which in turn transfers some of the T assets

to each of the ten subsidiaries. No one

subsidiary receives a significant portion of

T’s historic business assets. Each of the

subsidiaries will use the T assets in the

operation of its full service gas station. No P

subsidiary will be an auto parts distributor.

(ii) Continuity of business enterprise.

Under paragraph (d)(4)(i) of this section, P is

treated as conducting the ten gas station

businesses of S–1 through S–10 and as

holding the historic T assets used in those

businesses. P is treated as holding all the

assets and conducting the businesses of all of

the members of the qualified group, which

includes S–1 through S–10 (paragraphs

(d)(4)(i) and (ii) of this section). No member

of the qualified group continues T’s historic

distributorship business. However,

subsidiaries S–1 through S–10 continue to

use the historic T assets in a business. Even

though no one corporation of the qualified

group is using a significant portion of T’s

historic business assets in a business, the

COBE requirement of paragraph (d)(1) of this

section is satisfied because, in the aggregate,

the qualified group is using a significant

portion of T’s historic business assets in a

business.

Example 7. Continuation of the historic T

business in a partnership satisfies continuity

of business enterprise. (i) Facts. T

manufactures ski boots. P owns all of the

stock of S–1. S–1 owns all of the stock of S–

2, and S–2 owns all of the stock of S–3. T

merges into P and the T shareholders receive

consideration consisting of P stock and cash.

The T ski boot business is to be continued

and expanded. In anticipation of this

expansion, P transfers all of the T assets to

S–1, S–1 transfers all of the T assets to S–2,

and S–2 transfers all of the T assets to S–3.

S–3 and X (an unrelated party) form a new

partnership (PRS). As part of the plan of

reorganization, S–3 transfers all the T assets

to PRS, and S–3, in its capacity as a partner,

performs active and substantial management

functions for the PRS ski boot business,

including making significant business

decisions and regularly participating in the

overall supervision, direction, and control of

the employees of the ski boot business. S–3

receives a 20 percent interest in PRS. X

transfers cash in exchange for an 80 percent

interest in PRS.

(ii) Continuity of business enterprise.

Under paragraph (d)(4)(iii)(B)(2) of this

section, P is treated as conducting T’s

historic business because S–3 performs active

and substantial management functions for the

ski boot business in S–3’s capacity as a

partner. P is treated as holding all the assets

and conducting the businesses of all of the

members of the qualified group, which

includes S–3 (paragraphs (d)(4)(i) and (ii) of

this section). The COBE requirement of

paragraph (d)(1) of this section is satisfied.

Example 8. Continuation of the historic T

business in a partnership does not satisfy

continuity of business enterprise. (i) Facts.

The facts are the same as Example 7 except

that S–3 transfers the historic T business to

PRS in exchange for a 1 percent interest in

PRS.

(ii) Continuity of business enterprise.

Under paragraph (d)(4)(iii)(B)(2) of this

section, P is treated as conducting T’s

historic business because S–3 performs active

and substantial management functions for the

ski boot business in S–3’s capacity as a

partner. The fact that a significant historic T

business is conducted in PRS, and P is

treated as conducting such T business under

(d)(4)(iii)(B) tends to establish the requisite

continuity, but is not alone sufficient

(paragraph (d)(4)(iii)(C) of this section). The

COBE requirement of paragraph (d)(1) of this

section is not satisfied.

Example 9. Continuation of the T historic

business in a partnership satisfies continuity

of business enterprise. (i) Facts. The facts are

the same as Example 7 except that S–3

transfers the historic T business to PRS in
4180 Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations

exchange for a 331⁄3 percent interest in PRS,

and no member of P’s qualified group

performs active and substantial management

functions for the ski boot business operated

in PRS.

(ii) Continuity of business enterprise.

Under paragraph (d)(4)(iii)(B)(1) of this

section, P is treated as conducting T’s

historic business because S–3 owns an

interest in the partnership representing a

significant interest in that partnership

business. P is treated as holding all the assets

and conducting the businesses of all of the

members of the qualified group, which

includes S–3 (paragraphs (d)(4)(i) and (ii) of

this section). The COBE requirement of

paragraph (d)(1) of this section is satisfied.

Example 10. Use of T’s historic business

assets in a partnership business. (i) Facts. T

is a fabric distributor. P owns all of the stock

of S–1. T merges into P and the T

shareholders receive solely P stock. S–1 and

X (an unrelated party) own interests in a

partnership (PRS). As part of the plan of

reorganization, P transfers all of the T assets

to S–1, and S–1 transfers all the T assets to

PRS, increasing S–1’s percentage interest in

PRS from 5 to 331⁄3 percent. After the

transfer, X owns the remaining 662⁄3 percent

interest in PRS. Almost all of the T assets

consist of T’s large inventory of fabric, which

PRS uses to manufacture sportswear. All of

the T assets are used in the sportswear

business. No member of P’s qualified group

performs active and substantial management

functions for the sportswear business

operated in PRS.

(ii) Continuity of business enterprise.

Under paragraph (d)(4)(iii)(A) of this section,

S–1 is treated as owning 331⁄3 percent of the

T assets used in the PRS sportswear

manufacturing business. Under paragraph

(d)(4)(iii)(B)(1) of this section, P is treated as

conducting the sportswear manufacturing

business because S–1 owns an interest in the

partnership representing a significant interest

in that partnership business. P is treated as

holding all the assets and conducting the

businesses of all of the members of the

qualified group, which includes S–1

(paragraphs (d)(4)(i) and (ii) of this section).

The COBE requirement of paragraph (d)(1) of

this section is satisfied.

Example 11. Aggregation of partnership

interests among members of the qualified

group: use of T’s historic business assets in

a partnership business. (i) Facts. The facts

are the same as Example 10, except that S–

1 transfers all the T assets to PRS, and P and

X each transfer cash to PRS in exchange for

partnership interests. After the transfers, P

owns 11 percent, S–1 owns 221⁄3 percent, and

X owns 662⁄3 percent of PRS.

(ii) Continuity of business enterprise.

Under paragraph (d)(4)(iii)(B)(1) of this

section, P is treated as conducting the

sportswear manufacturing business because

members of the qualified group, in the

aggregate, own an interest in the partnership

representing a significant interest in that

business. P is treated as owning 11 percent

of the assets directly, and S–1 is treated as

owning 221⁄3 percent of the assets, used in

the PRS sportswear business (paragraph

(d)(4)(iii)(A) of this section). P is treated as

holding all the assets of all of the members

of the qualified group, which includes S–1,

and thus in the aggregate, P is treated as

owning 331⁄3 of the T assets (paragraphs

(d)(4)(i) and (ii) of this section). The COBE

requirement of paragraph (d)(1) of this

section is satisfied because P is treated as

using a significant portion of T’s historic

business assets in its sportswear

manufacturing business.

Example 12. Tiered partnerships: use of T’s

historic business assets in a partnership

business. (i) Facts. T owns and manages a

commercial office building in state Z.

Pursuant to a plan of reorganization, T

merges into P, solely in exchange for P stock,

which is distributed to the T shareholders. P

transfers all of the T assets to a partnership,

PRS–1, which owns and operates television

stations nationwide. After the transfer, P

owns a 50 percent interest in PRS–1. P does

not have active and substantial management

functions as a partner with respect to the

PRS–1 business. X, not a member of P’s

qualified group, owns the remaining 50

percent interest in PRS–1. PRS–1, in an effort

to expand its state Z television operation,

enters into a joint venture with U, an

unrelated party. As part of the plan of

reorganization, PRS–1 transfers all the T

assets and its state Z television station to

PRS–2, in exchange for a 75 percent

partnership interest. U contributes cash to

PRS–2 in exchange for a 25 percent

partnership interest and oversees the

management of the state Z television

operation. PRS–1 does not actively and

substantially manage PRS–2’s business. PRS–

2’s state Z operations are moved into the

acquired T office building. All of the assets

that P acquired from T are used in PRS–2’s

business.

(ii) Continuity of business enterprise.

Under paragraph (d)(4)(iii)(A) of this section,

PRS–1 is treated as owning 75 percent of the

T assets used in PRS–2’s business. P, in turn,

is treated as owning 50 percent of PRS–1’s

interest the T assets. Thus, P is treated as

owning 371⁄2 percent (50 percent x 75

percent) of the T assets used in the PRS–2

business. Under paragraph (d)(4)(iii)(B)(1) of

this section, P is treated as conducting PRS–

2’s business, the operation of the state Z

television station, and under paragraph

(d)(4)(iii)(A) of this section, P is treated as

using 371⁄2 percent of the historic T business

assets in that business. The COBE

requirement of paragraph (d)(1) of this

section is satisfied because P is treated as

using a significant portion of T’s historic

business assets in its television business.

(e) Continuity of interest—(1) General

rule. (i) The purpose of the continuity of

interest requirement is to prevent

transactions that resemble sales from

qualifying for nonrecognition of gain or

loss available to corporate

reorganizations. Continuity of interest

requires that in substance a substantial

part of the value of the proprietary

interests in the target corporation be

preserved in the reorganization. A

proprietary interest in the target

corporation is preserved if, in a

potential reorganization, it is exchanged

for a proprietary interest in the issuing

corporation (as defined in paragraph (b)

of this section), it is exchanged by the

acquiring corporation for a direct

interest in the target corporation

enterprise, or it otherwise continues as

a proprietary interest in the target

corporation. However, a proprietary

interest in the target corporation is not

preserved if, in connection with the

potential reorganization, it is acquired

by the issuing corporation for

consideration other than stock of the

issuing corporation, or stock of the

issuing corporation furnished in

exchange for a proprietary interest in

the target corporation in the potential

reorganization is redeemed. All facts

and circumstances must be considered

in determining whether, in substance, a

proprietary interest in the target

corporation is preserved. For purposes

of the continuity of interest

requirement, a mere disposition of stock

of the target corporation prior to a

potential reorganization to persons not

related (as defined in paragraph (e)(3) of

this section determined without regard

to paragraph (e)(3)(i)(A) of this section)

to the target corporation or to persons

not related (as defined in paragraph

(e)(3) of this section) to the issuing

corporation is disregarded and a mere

disposition of stock of the issuing

corporation received in a potential

reorganization to persons not related (as

defined in paragraph (e)(3) of this

section) to the issuing corporation is

disregarded.

(ii) [Reserved] For further guidance

see § 1.368–1T(e)(1)(ii)(A) and (B).

(2) Related person acquisitions. (i) A

proprietary interest in the target

corporation is not preserved if, in

connection with a potential

reorganization, a person related (as

defined in paragraph (e)(3) of this

section) to the issuing corporation

acquires, with consideration other than

a proprietary interest in the issuing

corporation, stock of the target

corporation or stock of the issuing

corporation furnished in exchange for a

proprietary interest in the target

corporation in the potential

reorganization, except to the extent

those persons who were the direct or

indirect owners of the target corporation

prior to the potential reorganization

maintain a direct or indirect proprietary

interest in the issuing corporation.

(ii) [Reserved] For further guidance

see § 1.368–1T(e)(2)(ii).

(3) Definition of related person—(i) In

general. For purposes of this paragraph

(e), two corporations are related persons

if either—

(A) The corporations are members of

the same affiliated group as defined in
Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations 4181

section 1504 (determined without

regard to section 1504(b)); or

(B) A purchase of the stock of one

corporation by another corporation

would be treated as a distribution in

redemption of the stock of the first

corporation under section 304(a)(2)

(determined without regard to § 1.1502–

80(b)).

(ii) Special rules. The following rules

apply solely for purposes of this

paragraph (e)(3):

(A) A corporation will be treated as

related to another corporation if such

relationship exists immediately before

or immediately after the acquisition of

the stock involved.

(B) A corporation, other than the

target corporation or a person related (as

defined in paragraph (e)(3) of this

section determined without regard to

paragraph (e)(3)(i)(A) of this section) to

the target corporation, will be treated as

related to the issuing corporation if the

relationship is created in connection

with the potential reorganization.

(4) Acquisitions by partnerships. For

purposes of this paragraph (e), each

partner of a partnership will be treated

as owning or acquiring any stock owned

or acquired, as the case may be, by the

partnership in accordance with that

partner’s interest in the partnership. If a

partner is treated as acquiring any stock

by reason of the application of this

paragraph (e)(4), the partner is also

treated as having furnished its share of

any consideration furnished by the

partnership to acquire the stock in

accordance with that partner’s interest

in the partnership.

(5) Successors and predecessors. For

purposes of this paragraph (e), any

reference to the issuing corporation or

the target corporation includes a

reference to any successor or

predecessor of such corporation, except

that the target corporation is not treated

as a predecessor of the issuing

corporation and the issuing corporation

is not treated as a successor of the target

corporation.

(6) Examples. For purposes of the

examples in this paragraph (e)(6), P is

the issuing corporation, T is the target

corporation, S is a wholly owned

subsidiary of P, all corporations have

only one class of stock outstanding, A

and B are individuals, PRS is a

partnership, all reorganization

requirements other than the continuity

of interest requirement are satisfied, and

the transaction is not otherwise subject

to recharacterization. The following

examples illustrate the application of

this paragraph (e):

Example 1. Sale of stock to third party. (i)

Sale of issuing corporation stock after

merger. A owns all of the stock of T. T

merges into P. In the merger, A receives P

stock having a fair market value of $50x and

cash of $50x. Immediately after the merger,

and pursuant to a preexisting binding

contract, A sells all of the P stock received

by A in the merger to B. Assume that there

are no facts and circumstances indicating

that the cash used by B to purchase A’s P

stock was in substance exchanged by P for T

stock. Under paragraphs (e)(1) and (2) of this

section, the sale to B is disregarded because

B is not a person related to P within the

meaning of paragraph (e)(3) of this section.

Thus, the transaction satisfies the continuity

of interest requirement because 50 percent of

A’s T stock was exchanged for P stock,

preserving a substantial part of the value of

the proprietary interest in T.

(ii) Sale of target corporation stock before

merger. The facts are the same as paragraph

(i) of this Example 1, except that B buys A’s

T stock prior to the merger of T into P and

then exchanges the T stock for P stock having

a fair market value of $50x and cash of $50x.

The sale by A is disregarded. The continuity

of interest requirement is satisfied because

B’s T stock was exchanged for P stock,

preserving a substantial part of the value of

the proprietary interest in T.

Example 2. Relationship created in

connection with potential reorganization. A

owns all of the stock of T. X, a corporation

which owns 60 percent of the P stock and

none of the T stock, buys A’s T stock for cash

prior to the merger of T into P. X exchanges

the T stock solely for P stock in the merger

which, when combined with X’s prior

ownership of P stock, constitutes 80 percent

of the stock of P. X is a person related to P

under paragraphs (e)(3)(i)(A) and (ii)(B) of

this section, because X becomes affiliated

with P in the merger. The continuity of

interest requirement is not satisfied, because

X acquired a proprietary interest in T for

consideration other than P stock, and a

substantial part of the value of the

proprietary interest in T is not preserved. See

paragraph (e)(2) of this section.

Example 3. Participation by issuing

corporation in post-merger sale. A owns 80

percent of the T stock and none of the P

stock, which is widely held. T merges into

P. In the merger, A receives P stock. In

addition, A obtains rights pursuant to an

arrangement with P to have P register the P

stock under the Securities Act of 1933, as

amended. P registers A’s stock, and A sells

the stock shortly after the merger. No person

who purchased the P stock from A is a

person related to P within the meaning of

paragraph (e)(3) of this section. Under

paragraphs (e)(1) and (2) of this section, the

sale of the P stock by A is disregarded

because no person who purchased the P

stock from A is a person related to P within

the meaning of paragraph (e)(3) of this

section. The transaction satisfies the

continuity of interest requirement because

A’s T stock was exchanged for P stock,

preserving a substantial part of the value of

the proprietary interest in T.

Example 4. Redemptions and purchases by

issuing corporation or related persons. (i)

Redemption by issuing corporation. A owns

100 percent of the stock of T and none of the

stock of P. T merges into S. In the merger,

A receives P stock. In connection with the

merger, P redeems all of the P stock received

by A in the merger for cash. The continuity

of interest requirement is not satisfied,

because, in connection with the merger, P

redeemed the stock exchanged for a

proprietary interest in T, and a substantial

part of the value of the proprietary interest

in T is not preserved. See paragraph (e)(1) of

this section.

(ii) Purchase of target corporation stock by

issuing corporation. The facts are the same as

paragraph (i) of this Example 4, except that,

instead of P redeeming its stock, prior to and

in connection with the merger of T into S,

P purchases 90 percent of the T stock from

A for cash. The continuity of interest

requirement is not satisfied, because in

connection with the merger, P acquired a

proprietary interest in T for consideration

other than P stock, and a substantial part of

the value of the proprietary interest in T is

not preserved. See paragraph (e)(1) of this

section. However, see § 1.338–2(c)(3) (which

may change the result in this case by

providing that, by virtue of section 338,

continuity of interest is satisfied for certain

parties after a qualified stock purchase).

(iii) Purchase of issuing corporation stock

by person related to issuing corporation. The

facts are the same as paragraph (i) of this

Example 4, except that, instead of P

redeeming its stock, S buys all of the P stock

received by A in the merger for cash. S is a

person related to P under paragraphs

(e)(3)(i)(A) and (B) of this section. The

continuity of interest requirement is not

satisfied, because S acquired P stock issued

in the merger, and a substantial part of the

value of the proprietary interest in T is not

preserved. See paragraph (e)(2) of this

section.

Example 5. Redemption in substance by

issuing corporation. A owns 100 percent of

the stock of T and none of the stock of P. T

merges into P. In the merger, A receives P

stock. In connection with the merger, B buys

all of the P stock received by A in the merger

for cash. Shortly thereafter, in connection

with the merger, P redeems the stock held by

B for cash. Based on all the facts and

circumstances, P in substance has exchanged

solely cash for T stock in the merger. The

continuity of interest requirement is not

satisfied, because in substance P redeemed

the stock exchanged for a proprietary interest

in T, and a substantial part of the value of

the proprietary interest in T is not preserved.

See paragraph (e)(1) of this section.

Example 6. Purchase of issuing corporation

stock through partnership. A owns 100

percent of the stock of T and none of the

stock of P. S is an 85 percent partner in PRS.

The other 15 percent of PRS is owned by

unrelated persons. T merges into P. In the

merger, A receives P stock. In connection

with the merger, PRS purchases all of the P

stock received by A in the merger for cash.

Under paragraph (e)(4) of this section, S, as

an 85 percent partner of PRS, is treated as

having acquired 85 percent of the P stock

exchanged for A’s T stock in the merger, and

as having furnished 85 percent of the cash

paid by PRS to acquire the P stock. S is a

person related to P under paragraphs
4182 Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations

(e)(3)(i)(A) and (B) of this section. The

continuity of interest requirement is not

satisfied, because S is treated as acquiring 85

percent of the P stock issued in the merger,

and a substantial part of the value of the

proprietary interest in T is not preserved. See

paragraph (e)(2) of this section.

Example 7. Exchange by acquiring

corporation for direct interest. A owns 30

percent of the stock of T. P owns 70 percent

of the stock of T, which was not acquired by

P in connection with the acquisition of T’s

assets. T merges into P. A receives cash in

the merger. The continuity of interest

requirement is satisfied, because P’s 70

percent proprietary interest in T is exchanged

by P for a direct interest in the assets of the

target corporation enterprise.

Example 8. Effect of general stock

repurchase program. T merges into P, a

corporation whose stock is widely held and

publicly traded and that has one class of

common stock outstanding. In the merger, T

shareholders receive common stock of P.

Immediately after the merger, P repurchases

a small percentage of its common stock in the

open market as part of its ongoing stock

repurchase program. The repurchase program

was not created or modified in connection

with the acquisition of T. Continuity of

interest is satisfied, because based on all of

the facts and circumstances, the redemption

of a small percentage of the P stock does not

affect the T shareholders’ proprietary interest

in T, because it was not in connection with

the merger, and the value of the proprietary

interest in T is preserved. See paragraph

(e)(1) of this section.

Example 9. Maintenance of direct or

indirect interest in issuing corporation. X, a

corporation, owns all of the stock of each of

corporations P and Z. Z owns all of the stock

of T. T merges into P. Z receives P stock in

the merger. Immediately thereafter and in

connection with the merger, Z distributes the

P stock received in the merger to X. X is a

person related to P under paragraph

(e)(3)(i)(A) of this section. The continuity of

interest requirement is satisfied, because X

was an indirect owner of T prior to the

merger who maintains a direct or indirect

proprietary interest in P, preserving a

substantial part of the value of the

proprietary interest in T. See paragraph (e)(2)

of this section.

(7) Effective date. This paragraph (e)

applies to transactions occurring after

January 28, 1998, except that it does not

apply to any transaction occurring

pursuant to a written agreement which

is binding on January 28, 1998, and at

all times thereafter.

Par. 4. Section 1.368–2 is amended

by:

1. Removing the second sentence of

paragraph (a) and adding two sentences

in its place.

2. Removing the second sentence of

paragraph (f) and adding four sentences

in its place.

3. Removing the second sentence in

paragraph (j)(1).

4. Revising paragraph (j)(3)(ii).

5. Revising the first sentence in

paragraph (j)(3)(iii).

6. Adding paragraph (j)(3)(iv).

7. Removing paragraph (j)(4).

8. Redesignating paragraphs (j)(5),

(j)(6), and (j)(7) as (j)(4), (j)(5), and (j)(6),

respectively.

9. Removing the parentheses around

the numbers in the paragraph headings

for Example (1) through Example (9) in

newly designated paragraph (j)(6).

10. Adding paragraph (k).

The additions and revisions read as

follows:

§ 1.368–2 Definition of terms.

(a) * * * The term does not embrace

the mere purchase by one corporation of

the properties of another corporation.

The preceding sentence applies to

transactions occurring after January 28,

1998, except that it does not apply to

any transaction occurring pursuant to a

written agreement which is binding on

January 28, 1998, and at all times

thereafter. * * *

* * * * *

(f) * * * If a transaction otherwise

qualifies as a reorganization, a

corporation remains a party to the

reorganization even though stock or

assets acquired in the reorganization are

transferred in a transaction described in

paragraph (k) of this section. If a

transaction otherwise qualifies as a

reorganization, a corporation shall not

cease to be a party to the reorganization

solely by reason of the fact that part or

all of the assets acquired in the

reorganization are transferred to a

partnership in which the transferor is a

partner if the continuity of business

enterprise requirement is satisfied. See

§ 1.368–1(d). The preceding three

sentences apply to transactions

occurring after January 28, 1998, except

that they do not apply to any transaction

occurring pursuant to a written

agreement which is binding on January

28, 1998, and at all times thereafter.

* * *

* * * * *

(j) * * *

(3) * * *

(ii) Except as provided in paragraph

(k)(2) of this section, the controlling

corporation must control the surviving

corporation immediately after the

transaction.

(iii) After the transaction, except as

provided in paragraph (k)(2) of this

section, the surviving corporation must

hold substantially all of its own

properties and substantially all of the

properties of the merged corporation

(other than stock of the controlling

corporation distributed in the

transaction). * * *

(iv) Paragraphs (j)(3)(ii) and (iii) of

this section apply to transactions

occurring after January 28, 1998, except

that they do not apply to any transaction

occurring pursuant to a written

agreement which is binding on January

28, 1998, and at all times thereafter.

* * * * *

(k) Transfer of assets or stock in

section 368(a)(1)(A), (B), (C), or (G)

reorganizations—(1) General rule for

transfers to controlled corporations.

Except as otherwise provided in this

section, a transaction otherwise

qualifying under section 368(a)(1)(A),

(B), (C), or (G) (where the requirements

of sections 354(b)(1)(A) and (B) are met)

shall not be disqualified by reason of the

fact that part or all of the acquired assets

or stock acquired in the transaction are

transferred or successively transferred to

one or more corporations controlled in

each transfer by the transferor

corporation. Control is defined under

section 368(c).

(2) Transfers following a reverse

triangular merger. A transaction

qualifying under section 368(a)(1)(A) by

reason of the application of section

368(a)(2)(E) is not disqualified by reason

of the fact that part or all of the stock

of the surviving corporation is

transferred or successively transferred to

one or more corporations controlled in

each transfer by the transferor

corporation, or because part or all of the

assets of the surviving corporation or

the merged corporation are transferred

or successively transferred to one or

more corporations controlled in each

transfer by the transferor corporation.

(3) Examples. The following examples

illustrate the application of this

paragraph (k). P is the issuing

corporation and T is the target

corporation. P has only one class of

stock outstanding. The examples are as

follows:

Example 1. Transfers of acquired assets to

controlled corporations. (i) Facts. T operates

a bakery which supplies delectable pastries

and cookies to local retail stores. The

acquiring corporate group produces a variety

of baked goods for nationwide distribution. P

owns 80 percent of the stock of S–1. Pursuant

to a plan of reorganization, T transfers all of

its assets to S–1 solely in exchange for P

stock, which T distributes to its shareholders.

S–1 owns 80 percent of the stock of S–2; S–

2 owns 80 percent of the stock of S–3, which

also makes and supplies pastries and cookies.

Pursuant to the plan of reorganization, S–1

transfers the T assets to S–2; S–2 transfers the

T assets to S–3.

(ii) Analysis. Under this paragraph (k), the

transaction, otherwise qualifying as a

reorganization under section 368(a)(1)(C), is

not disqualified by reason of the fact of the

successive transfers of all of the acquired

assets from S–1 to S–2, and from S–2 to S–

3 because in each transfer, the transferee

corporation is controlled by the transferor
Federal Register / Vol. 63, No. 18 /Wednesday, January 28, 1998 /Rules and Regulations 4183

corporation. Control is defined under section

368(c).

Example 2. Transfers of acquired stock to

controlled corporations. (i) Facts. The facts

are the same as Example 1 except that S–1

acquires all of the T stock rather than the T

assets, and as part of the plan of

reorganization, S–1 transfers all of the T

stock to S–2, and S–2 transfers all of the T

stock to S–3.

(ii) Analysis. Under this paragraph (k), the

transaction, otherwise qualifying as a

reorganization under section 368(a)(1)(B), is

not disqualified by reason of the fact of the

successive transfers of all of the acquired

stock from S–1 to S–2, and from S–2 to S–

3 because in each transfer, the transferee

corporation is controlled by the transferor

corporation.

Example 3. Transfers of acquired stock to

partnerships. (i) Facts. The facts are the same

as in Example 2. However, as part of the plan

of reorganization, S–2 and S–3 form a new

partnership, PRS. Immediately thereafter, S–

3 transfers all of the T stock to PRS in

exchange for an 80 percent partnership

interest, and S–2 transfers cash to PRS in

exchange for a 20 percent partnership

interest.

(ii) Analysis. This paragraph (k) describes

the successive transfer of the T stock to S–

3, but does not describe S–3’s transfer of the

T stock to PRS. Therefore, the

characterization of this transaction must be

determined under the relevant provisions of

law, including the step transaction doctrine.

See § 1.368–1(a). The transaction fails to meet

the control requirement of a reorganization

described in section 368(a)(1)(B) because

immediately after the acquisition of the T

stock, the acquiring corporation does not

have control of T.

(4) This paragraph (k) applies to

transactions occurring after January 28,

1998, except that it does not apply to

any transaction occurring pursuant to a

written agreement which is binding on

January 28, 1998, and at all times

thereafter.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: January 12, 1998.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 98–1819 Filed 1–23–98; 12:15 pm]

BILLING CODE 4830–01–U

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8761]

RIN 1545–AV80

Continuity of Interest

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains

temporary regulations providing

guidance regarding satisfaction of the

continuity of interest requirement for

corporate reorganizations. The

temporary regulations affect

corporations and their shareholders.

Final regulations published elsewhere

in this issue of the Federal Register also

provide guidance regarding satisfaction

of the continuity of interest requirement

for corporate reorganizations. These

temporary regulations amplify the final

regulations. The text of these temporary

regulations also serves as the text of

proposed regulations published

elsewhere in this issue of the Federal

Register.

DATES: These regulations are effective

January 28, 1998.

Applicability: These regulations apply

to transactions occurring after January

28, 1998, except that they do not apply

to any transaction occurring pursuant to

a written agreement which is (subject to

customary conditions) binding on

January 28, 1998, and at all times

thereafter.

FOR FURTHER INFORMATION CONTACT:

Phoebe Bennett, (202) 622–7750 (not a

toll-free number).

SUPPLEMENTARY INFORMATION: This

document contains amendments to the

Income Tax Regulations (26 CFR part 1)

under section 368. These temporary

regulations provide that, in determining

whether the continuity of interest

requirement for corporate

reorganizations is satisfied with respect

to a potential reorganization, a

proprietary interest in the target

corporation is not preserved if, in

connection with a potential

reorganization, it is redeemed or

acquired by a person related to the

target corporation, or to the extent that,

prior to and in connection with a

potential reorganization, an

extraordinary distribution is made with

respect to it.

Background

On December 23, 1996, the IRS

published a notice of proposed

rulemaking (REG–252231–96) in the

Federal Register (61 FR 67512) relating

to the continuity of interest

requirement. Many written comments

were received in response to this notice

of proposed rulemaking. A public

hearing on the proposed regulations was

held on May 7, 1997. After

consideration of all comments, the

regulations proposed by REG–252231–

96 are adopted as final regulations, and

published elsewhere in this issue of the

Federal Register. These temporary

regulations supplement the final

regulations.

Explanation of Provisions

Final regulations published elsewhere

in this issue of the Federal Register

provide that in determining whether the

continuity of interest (COI) requirement

for corporate reorganizations is satisfied,

dispositions of stock of the target

corporation (T) by a T shareholder

generally are not taken into account.

Redemptions of T Stock or

Extraordinary Distributions With

Respect to T Stock

Commentators requested guidance on

the circumstances under which a

redemption by T of its stock would

adversely affect satisfaction of the COI

requirement.

Some commentators suggested that

the IRS and Treasury Department adopt

an approach that would identify either

the issuing corporation (P) or T as the

source of the funds for the redemption.

If, in connection with an acquisition of

T, the facts and circumstances indicate

that P did not directly or indirectly

furnish funds used by T to redeem T

shareholders, these commentators

suggested that satisfaction of the COI

requirement should not be adversely

affected. In many transactions, however,

such a tracing approach would be

extremely difficult to administer. For

example, if P acquired the assets, rather

than the stock, of T or if T redeemed

stock for a note, it would be unclear in

many circumstances whether in

substance T or P assets were used to

fund the redemption or to repay the

note.

Another commentator suggested that

redemptions by T in connection with a

potential reorganization should

adversely affect satisfaction of the COI

requirement because the effect on COI is

the same as if P had furnished the

redemption consideration in the

transaction. The temporary regulations

generally adopt this approach because it

reflects that T and P will be combined

economically and because of the

difficulties of administering a tracing

approach, as previously described.

Treatment of stock redeemed by T as

proprietary interests that are not

preserved in the reorganization also

accords the same tax result to

transactions that reach the same result

by different steps. For example, T could

merge into P for a combination of

consideration, of which 30 percent is P

stock and 70 percent is a P promissory

note. Conversely, T could issue its

promissory note to redeem 70 percent of

the T stock and then P would assume

the T note in the merger, in which the